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six ways companies mismanage risk

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six ways companies mismanage risk
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Six Ways Companies
Mismanage Risk by René M. Stulz

Reprint R0903G

Six Ways Companies
Mismanage Risk by René M. Stulz

COPYRIGHT © 2009 HARVARD BUSINESS SCHOOL PUBLISHING CORPORATION. ALL RIGHTS RESERVED.

As investors tot up their losses from the financial crisis, many will be asking themselves,
How did Wall Street mess up so badly?
What went wrong with all those complicated models? Even back in November 2007, before the crisis had really hit the stock markets, one commentator in the Financial Times wrote, “It is obvious there has been a massive failure of risk management across most of
Wall Street.”
Of course, financial institutions can suffer spectacular losses even when their risk management is first-rate. They are, after all, in the business of taking risks. When risk management does fail, however, it is in one of six basic ways, nearly all of them exemplified in the current crisis. Sometimes the problem lies with the data or measures that risk managers rely on. Sometimes it relates to how they identify and communicate the risks a company is exposed to. Financial risk management is hard to get right in the best of times.
In the following pages I’ll explore the six paths to failure in detail.

1. Relying on Historical Data
Risk-management modeling usually involves extrapolating from the past to forecast the probability that a given risk will materialize.
Let’s assume you were a bank’s risk manager in 2006, and you were worried about the chances that real estate prices would plunge over the coming year. Your bank’s top executives needed to know how likely such a plunge was and what losses it would cause in order to decide how much exposure the bank should have to real estate prices.
You would have begun by examining the historical volatility of house prices and then calculating the one-year mean price change and its standard deviation, on the assumption that they would provide a good approximation

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